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EU Enlargement and Endogeneity of some OCA Criteria: Evidence from the CEECs

Ian Babetskii

There are two opposite points of view on the link between economic integration and business
cycle synchronization. De Grauwe (1997) classifies these competing views as 'The European
Commission View' and 'The Krugman View'. According to the European Commission (1990), closer
integration leads to less frequent asymmetric shocks and to more synchronized business cycles
between countries. On the other hand, for Krugman (1993) closer integration implies higher
specialization and, thus, higher risks of idiosyncratic shocks. Drawing on the evidence from a
group of transition countries which have experienced a notable increase in trade openness and
economic integration with the European Union during the past decade, this paper tries to determine
whose argument is supported by the data. This is done by confronting estimated time-varying
coefficients of supply and demand shock asymmetry with indicators of trade intensity and exchange
rates. We find that (i) an increase in trade intensity leads to higher symmetry of demand shocks;
the effect of integration on supply shock asymmetry varies from country to country; (ii) a decrease
in exchange rate volatility has a positive effect on demand shock convergence. The results for
demand shocks can be interpreted in favor of 'The European Commission View', also known as the
endogeneity argument by Frankel and Rose (1998) in the OCA criteria discussion, according to which
trade links reduce asymmetries between countries. Overall, our results support Kenen's (2001)
argument that the impact of trade integration on shock asymmetry depends on the type of shock.